Overdue Market Correction Fueled by Uncertainty
Will Upcoming Earnings Season Save the Day?
Please view our most recent update from Founder and CIO, James Demmert: An Updated Message From Our Founder
A few months ago, global stock markets were surging on the promise of a new administration, a resilient economy, and the potential tailwinds of Artificial Intelligence (AI). Much of that market strength was based on an abundance of investor confidence, particularly around US stocks, which were deemed "exceptional." As suggested in previous Strategy Updates, investors should beware of periods when investor "crowd psychology" becomes overly confident, mainly because the periods following heightened levels of optimism rarely unfold as smoothly and flawlessly as those wearing "rose-colored glasses" envision. You may recall our anticipation of an overdue market correction in our year-end Strategy Update and subsequent discussions this past quarter. We had been suggesting that this event may startle investors, given the lack of volatility in recent quarters. In hindsight, we should have used a stronger term for this, as investors were more than startled. So far, this normal stock market correction has received, in our opinion, overwrought media attention, volatility metrics, and bearish investor sentiment. At this time, the major market indexes have declined about 12% from their highs and are only down about 8% for the year – well within the range of what is considered a normal correction. So why has this period of market fluctuation heightened investor concern above normal levels? Might this be the beginning of something worse? Let's dig in and explore where markets go from here.
Long Overdue Correction Fueled by Policy Uncertainty
After the first few years, bull markets typically experience two or three 10-12% corrections per year. As we enter the third year of this robust bull market, we speculate that this type of volatility will be the norm going forward. We like to say that bull markets ebb and flow based on investor psychology and confidence being too ahead or behind realistic expectations for economic and earnings growth – hence the ensuing volatility. In most cases, market corrections kick off due to uncertainty about the economy, earnings, or, in this case, presidential policy. The first 100 days of this administration have created an unprecedented level of uncertainty, which has been the "perfect storm" for global stock markets that were already overdue for a pullback. Is it possible that the new administration's policies, such as tariffs, fiscal austerity, and protectionism, will derail the bull market and that this recent market weakness will unravel into something much worse? Let's drill down into this.
Political Policies' Effect on the Economy and Corporate Profits
It's difficult to speculate with certainty how US policy shifts will affect economic and corporate earnings growth. In the short term, tariffs will create significant negative shifts for specific sectors and companies. We believe that stock markets have already discounted most of this bad news. A glance at the decline in steel companies and other related stocks shall suffice. As your investment advisor, we aim to keep you insulated from tariff-sensitive exposure, and so far, we have been successful. Policies such as fiscal austerity can be a blow to economic growth, namely GDP, in the short term. However, if effective, they can provide the path to a balanced budget – something we haven't seen since the '90s. Lower taxes may seem like an oxymoron regarding fiscal austerity; however, a balanced budget could lead to lower taxes. It's a fine line to try to execute these policies simultaneously, and it has created significant uncertainty, manifested in the downward behavior of global stock markets in recent months. From our vantage point, much of the negative tariff news is already priced in, and global equity markets are extremely oversold, meaning the next big move may very well be up. In stark contrast to our year-end levels, investor sentiment is now historically pessimistic – a sign of better times ahead. If markets receive good news, it could drive certainty back into the fold.
Economic Growth Remains Resilient
The recent meeting of the Federal Reserve confirmed that the economy continues to grow at a healthy pace – not too fast, yet not too slow. Given this healthy balance, Fed officials saw no reason to change interest rates from current levels. A moderate level of growth in the economy paired with inflation under 3% is an excellent stage for stock price performance. We monitor economic data each week, reflecting this balance of a strong labor market, volatile consumer confidence, and subdued inflation. Keep in mind that should this healthy path of economic growth show signs of stalling, the Fed is well-armed and prepared to lower rates to inject stimulus.
Corporate Earnings Growth May Provide Investor Certainty
Quarterly profit reports start in earnest on April 11th, kicked off by the big banks and other financial institutions. We think this may be what markets need to remind investors that what really drives stocks are earnings and economic growth. We also believe the upcoming earnings season will be better than expected across most sectors, likely to breathe new optimism back into the investor consciousness and serve as support for equity prices. Tariffs will no doubt negatively affect certain parts of the market, and we will continue to strive to avoid those areas. We hope the upcoming earnings season will remind investors that tariffs have little effect on most segments of the market. Some of the most attractive themes of this bull market, AI, technology, and telecom, have little tariff impact and now, given the recent pullback, represent significant future value.
Global Stocks Reasonably Priced and Attractive
The recent correction has created more attractive valuations in the US and abroad. The average US stock trades at just 16.5 times earnings, which is cheap relative to historical averages, while European equities trade at a fraction of this multiple. Keep in mind that US austerity is causing both Europe and China to increase fiscal spending, which is bullish for those stocks and markets. As you know, we are a global investor and have used the recent volatility to increase our exposure in these attractive markets on your behalf.
Risks of the Known and Unknown
As we have mentioned, it is hard to know with certainty if the policies in DC will succeed and either support the current bull market or derail it. We will closely watch these trends and policies and remain agile in managing your portfolio. We would caution investors against speculating the future direction of markets based on political policy since it can often change on a dime – as we have witnessed multiple times in recent months! If, for some reason, stocks begin to fall more than normal – which has yet to be the case – keep in mind that our Active Risk Management process will engage. This process allows for the flexible reduction of your stock exposure, management of your exposure to sectors of the economy, and the use of carefully placed stop loss orders. This has been an effective process to mitigate losses in past bear markets, and we believe it will continue to be valuable.
Thank you from all of us for your vote of confidence in our work during this uncertain time.
If you have family, friends, or colleagues who might benefit from this update, please share it with them.